Workers who choose a defined-contribution plan could lose a big tax break. Or not. But the agency wont say.

Financially troubled cities got some good news this week when a federal judge ruled that the pensions of Detroits employees could be cut in a bankruptcy proceeding. The leverage provided by Judge Steven Rhodess decision may help bring public unions elsewhere to the bargaining table, but cities face another obstacle to pension reform: the Internal Revenue Service.

For more than three years the IRS has failed to clarify a rule on changes to public pension systems that would allow municipalities to shift workers into new, less-expensive plans without losing any tax advantages they had under the old plan.

The issue flared up in 2009, when officials in Californias Orange County negotiated an agreement with their union that included giving workers the option of moving from their expensive, defined-benefit pension into a hybrid plan featuring a less-costly defined-benefit combined with a 401(k). The plan saves the county money—at least $10 million annually and potentially much more, depending on how many workers sign up—and it also increases worker take-home pay by cutting employee contributions to the plan.

The Orange County Employees Association accepted the new plan to let workers choose more take-home pay now, but there was an unexpected glitch. Local government contributions into a defined-benefit pension arent counted as part of an employees taxable wages. However, officials discovered that thanks to a murky ruling a few years earlier, the IRS might decide that a portion of the employees pension contributions are taxable if a worker moves into a plan such as the one offered by Orange County. Such a ruling would remove a key tax-savings for the employee and probably cause most workers to avoid the new plan.

Orange County officials, worried about the tax issue, asked the IRS to endorse the idea of giving workers a one-time chance to join a cheaper system without any tax penalty. They got no answer. Since then the county and the union have continued to press for a ruling, including hiring a Washington law firm to lobby the IRS.

"There is no legitimate reason to deny localities this tool," San Diego City Attorney Jan Goldsmith told the San Diego Union-Tribune in April 2012, expressing the frustration of many municipal officials over the federal governments failure to make a decision.

Other cities that have adopted or are considering similar pension reforms—including San Jose, San Diego and Mesa, Ariz.—have also petitioned for clarification. National groups like the U.S. Conference of Mayors and the National League of Cities have similarly urged the IRS to endorse the changes sought by cities.

So far, Orange Countys hybrid plan is on hold for city workers in the old plan. Meanwhile, total pension contributions by the county government and employees soared to $628 million last year, up from $545 million in 2009.

Last year, San Jose voters approved a pension reform championed by its mayor, Chuck Reed, that requires current employees to contribute more out of their own pockets to their retirement costs. As an alternative, however, workers can shift into a new, less expensive plan that reduces benefits but doesnt oblige employees to pay more. But until the IRS clears up the tax issue, going ahead could prove risky for the city and its workers. "Nothing is ever easy in this area," Mr. Reed said recently, noting that the IRS doesnt seem to view employee choice on pensions favorably.

Earlier this year, several members of Congress introduced a bill that would amend the IRS code to permit the kinds of changes enacted by San Jose and Orange County. "The federal government should not be standing in the way of states, cities and counties that are attempting to take the initiative in solving their own deficit problems," co-sponsor John Campbell, a Republican representing part of Orange County, said when the bill was introduced in January. The bill has bipartisan backing, including Democrat Loretta Sanchez, who also represents one of Orange Countys congressional districts.

But so far the bill has gone nowhere, in part because of union opposition. In August, Ms. Sanchez told the press that the American Federation of State, County and Municipal Employees and others are unhappy because clarification of the tax issue would spur more cities to move current employees into hybrid plans that feature defined contribution options.

Defined-contribution plans are like the 401(k)s that more than 50 million Americans use to save for their retirement. But according to Sandra Fox, president of Afscme Local 2076 in California, theyre too risky. "Lets say you do the wrong investment. What happens? You lose everything."

The IRS has failed, for years, to resolve the pension issue. It has appeared several times on an annual list of priorities the IRS says it intends to address, but that has yet to result in any ruling. And the IRS doesnt comment on pending matters.

Why are the bureaucrats sitting on their hands? Some critics believe the delay is thanks to the big government unions in Washington. The IRS is part of the U.S. Treasury, and from what he has been able to learn, Orange County Supervisor John M.W. Moorlach believes these unions "have a stranglehold on the Treasury Department."

Regardless of where the blame lies, the need for a solution is pressing. "Cities and counties all over America are losing their grip on solvency, and pension costs are often a factor," says Mr. Moorlach. "Offering employees a cheaper plan is a way to curb costs while attempting to sidestep whats really the only other option: a showdown" with unions rather than a negotiated settlement like the one in Orange County. Ms. Sanchez has put it more simply: "We dont want to end up like Detroit."